In order to understand the various types of annuities when determining if one is right for you, it is important to have a basic understanding of how all annuities work.
Annuities have 2 main phases associated with them. They are the deferral phase and the income phase (also called the annuity phase).
We'll begin with the income phase. Annuities are designed to give the contract owner guaranteed income. The income can be set to last for a certain period of years such as 5, 10, or 15 years or it can be set up to pay the owner for his or her entire life.
When period certain is chosen. It is usually for the purpose of being a stop gap measure to provide income for a time until another source of income begins. An example of this is when a person retires from their job, but social security payments are not scheduled to begin for 3 or 4 more years. The annuity provides the income during that time.
When lifetime income is chosen, it transfers the longevity risk to the insurance company. Longevity risk is the risk that you will outlive your money. Using a lifetime annuity payment insures that your income will never cease during your lifetime and it is the prime feature of an annuity.
When a customer purchases an annuity that pays income starting immediately after purchase, that annuity is called an immediate annuity.
A deferred annuity is used when a person wants to have guaranteed income, but does not want that income to begin until a later date. That later date is commonly the owners retirement date and can be only a few years away or many years away.
Deferred annuities can be purchased with one single payment, called a single premium deferred annuity. Or it can be purchased with regular or semi regular payments over time. This is called a flexible premium deferred annuity.
After purchase a deferred annuity continues to grow in value while the guaranteed income payments are deferred. One of the features of a deferred annuity is that the annuity grows tax deferred, which means you do not pay taxes each year on the growth. Instead you pay income taxes on the growth amount when you withdraw the money (the income phase).
The way a deferred annuity grows can either be by a guaranteed fixed interest rate or tied to the stock and bond markets and thus have variable growth that is non guaranteed but potentially much greater than the fixed rate growth.
Deferred annuities usually have provisions allowing the contract to be cancelled or surrendered either partially or in full before the income phase begins. In practice, annuities are often treated more as a savings vehicle rather than the guaranteed income vehicle they were meant to be.